Direct the Rein to Sail Along the Ocean

Transcription

1 Direct the Rein to Sail Along the Ocean The destination has been vowed, the ark moves bravely facing the wave in the middle of the sea. Let the helmsman takes control and negotiates with the situation to tie-up safely at the piers i

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3 CHAPTER III MONETARY POLICY RESPONSE TO GLOBAL ECONOMIC CRISIS

4 Indonesia Monetary Policy Response amidst Global Economic Crisis The global economic crisis, still lingering in 2009, has put enormous pressure on the country s monetary policy as manifested particularly in the increasingly unstable domestic financial system. Such a prolonged global economic slump had led to a considerable short-term capital outflow in the first quarter of 2009, significantly undermining the country s stock and bond market performance, putting a strain on the rupiah exchange rate, and carrying added risks to the domestic banking industry. Such a blow to the country s financial system should not be left unchecked since it may undo the numerous positive outcomes previously brought about by the country s macroeconomic stability. The monetary policy taken in response to such a pressure was aimed not only at striking a harmonious balance between targeted price stability and economic growth, but also at safeguarding the country s financial system stability. By taking into account indications of decline in inflationary pressure, the country s monetary policy has been directed to take a loose stance in order to prevent the country s economic growth from decelerating even further and to maintain the country s financial system stability. Following a series of policies pursued in the last quarter of 2008, Bank Indonesia lowered the BI Rate significantly in This policy has been supported by several other policies made operational both on rupiah money markets as well as foreign currency markets. Such supporting policies were intended to boost confidence over the 78

5 availability of short term liquidity to support money market activities, at the same time optimizing the management of bank liquidity. A series of policies taken since the last quarter of 2008 had been able to support the process of stability recovery in the financial sector. This recovery has taken effect starting from the second quarter of This was reflected in the decline of various risks within the financial market, and in the prevention of the rupiah exchange rate to further depreciate. This condition was quite favorable in order to restore the performance of the real sector. The real sector itself has started to pick up since the beginning of the second semester of In the future, the monetary policy will still face various challenges. Firstly, the still dominant share of portfolio investment within the capital inflow structure poses a risk of putting an increasing strain on the rupiah exchange rate in times of capital flows reversal. Secondly, the persistently vast excess banking liquidity has the potential to reduce the effectiveness of monetary policy. Thirdly, there are still unresolved structural issues in the real sector, including constraints in the supply side and market structure. Constraints on the supply side will make an increase in demand easily trigger inflationary pressure. Meanwhile, the still distorted market will make it harder for prices to go down. This chapter will be further divided into five parts. The first part will discuss various responses and monetary policy achievements throughout The second part will explain the dynamics of capital inflows and the implication toward exchange rate stability. The third part will provide elaboration on various issues potentially distorting the works of monetary policy transmission mechanism. The fourth part will discuss constraints in the supply side, market structure, and their implications toward inflation. The last part is a conclusion. Monetary Policy Response to Global Economic Crisis CHAPTER III 79

6 Monetary Response in Throughout 2009, Bank Indonesia took a measured, loose monetary policy stance to promote national economic recovery. As inflationary pressure remained low, the monetary policy was made in a measured response to ongoing economic development. Such a response was aimed not only at minimizing the negative effects of global economic downturn, but also at maintaining the resilience of the country s macro economy and domestic financial system as a basis to reach a high quality economic growth. This stance was picked in line with the implementation of a flexible ITF framework over the last five years in a bid to reach a harmony between achieving inflation target and economic growth (Box 3.1. Entering the 5th year of ITF Implementation in Indonesia: Success and Challenges). The measured, loose monetary policy stance can be seen in the development of BI Rate which tended to move downward in a varied pace over three different periods. In those three periods, BI Rate was set based on overall latest economic condition and the economic prospect. The first episode was in January-March 2009 when BI Rate was reduced aggressively at 50 bps monthly. Such an aggressive BI Rate cut was taken to anticipate tight pressure on the financial system and the slowdown in economic growth trend which is expected to be prolonged, while future inflationary pressure was predicted to be weak. The second episode was in April- August 2009 when BI Rate was cut by 25 bps per month. This policy was taken upon considering that the pressure on the financial system was beginning to decline and the condition of minimal inflationary pressure, while economic growth acceleration was still not sufficient. The 80 CHAPTER III Monetary Policy Response to Global Economic Crisis

7 third episode was in September-December 2009 when BI Rate was kept on hold. As the financial system condition improved over time, the unchanged level of BI Rate was consistent with the efforts to reach the inflation target in , yet it still provided ample room for the economic recovery. The widespread financial crisis in developed countries weighing on global economic growth brought about quite strong pressure to the Indonesian economy chiefly in fourth quarter The impact was observed in a significantly slower economic expansion due to a fall in exports. The balance of payments suffered from a surging deficit and rupiah exchange rate was severely depreciated. Foreign capital flow reversal pushed the risk in interbank money market up, 44 sent stock market indices to nosedive, and raised SUN yield to a high level. The weakening economic activity is also registered on slower expansion of liquidity and credit. Responding to a weak future inflationary pressure, in January-March 2009 the BI Rate was lowered by 50 bps per month, making it stand at 7.75% in March In addition, Bank Indonesia took a number of policies in the foreign exchange market to ease an excessive pressure in exchange rate volatility while maintaining liquidity adequacy in domestic foreign exchange market. Since 30 January 2009 Bank Indonesia also launched a foreign exchange repurchase agreement instrument (repo) by applying Republic of Indonesia Global Bond as transaction collateral. 45 With the policy in place, domestic banks could repo their own Indonesian Government Global Bond to Bank Indonesia to fulfill their foreign exchange liquidity needs. In subsequent developments, positive sentiment from the global financial market began to rise in mid March 2009 bringing foreign capital flows back to emerging markets including Indonesia. This condition in turn helped ease exchange rate pressure. The recovery in global commodity prices along with the positive sentiment over global financial market recovery brought the Indonesia Composite Index up and SUN yield down albeit limitedly since mid March Positive sentiment also sparked over growing foreign exchange reserves generated from 44 Reflected in some indicators, including the decline in PUAB outstanding position, shrinking PUAB volume and actors, rising spread between PUAB O/N floor and ceiling interest rate, widening JIBOR spread in various maturities, a shift in the augmentation of banking excess liquidity stock placement to shorter term. 45 PBI No. 11/4/2009 on US dollar Transaction of Bank Repurchase Agreement to Bank Indonesia dated on 30 January the sales of Indonesian Government Global Medium Term Notes (GMTN). The positive sentiment grew stronger upon the enhancement of cooperation to raise the amount of Bilateral Swap Arrangement (BSA) with Japan and Bilateral Currency Swap Arrangement (BCSA) with China. Those policies and positive sentiments could eventually relax the pressure on rupiah depreciation in the whole first quarter At the end of March 2009, the rupiah depreciated by 5.7% to Rp11,555 to the US dollar with a volatility of 1.0%. 46 This depreciation was lower than that of the last quarter of 2008 recorded at 13.8% with a 2.4% volatility. 47 Such an exchange rate development remained in line with conditions in regional countries. The early signals of global economic recovery drove the improvement in risk perception against both global and domestic economies. The effect of the improved global risk perception was mainly supported by economic recovery momentum in the Asian region continuing since early April The condition served as one of the supporting factors in restoring domestic export performance, especially for natural-resourced based commodities. In addition, a growing optimism over the recovery of global economy, heightened by the improvement in risk perception against assets in the emerging markets, drove foreign capital inflow back speedily. In the middle of insufficient economic growth and the expectation for a mild inflationary pressure in the future, the initial global economic recovery served as a base for adjustment in BI Rate (a decrease of 25 bps per month). Thus in August 2009, the BI rate stood at 6,5%. In addition, to give a guarantee and temporary cushion for the banking liquidity availability Bank Indonesia launched a 1-month window repo instrument since mid April Gradual and consistent monetary policy easing taken amid the continued global economic recovery helped improve various domestic economic indicators. Increases in capital flows and exports were mirrored in the balance of payments surplus. Foreign capital flows also contributed to the lifting of Indonesia Composite Index, while SUN yield moved downward closer to the precrisis condition (Chart 3.1). Improvement also occurred in the domestic foreign exchange market, as shown by rupiah appreciation of 14.6% between the end of March to the end of August 2009, rupiah eventually closed at Rp10,080 per US dollar (Chart 3.2). Despite strengthening, 46 Or by an average of Rp per US dollar. 47 Depreciated by an average of 15.3%. Monetary Policy Response to Global Economic Crisis CHAPTER III 81

8 index percent Rp/USD billions of USD 3,000 2,500 2,000 1,500 1, ,500 12,000 11,500 11,000 10,500 10,000 9,500 9, Jan - 06 Apr- 06 Jul - 06 Oct - 06 Jan - 07 Apr- 07 Jul - 07 Oct - 07 Jan - 08 Apr- 08 Jul - 08 Oct - 08 Jan - 09 Apr- 09 Jul - 09 Oct - 09 Jan ,500 I II III IV I II III IV I II III IV I II III IV I II III IV JCI Yield of Goverment Bond (rhs) BI Rate (rhs) Exchange Rate International Reserve (rhs) Source: Bloomberg (processed) Source: Bloomberg (processed) Chart 3.1 JCI, Governtment Bond, and BI Rate Chart 3.2 Exchange Rate and International Reserve rupiah appreciation remained supportive of Indonesian export competitiveness. In the end, these developments help built confidence on a sustained recovery process in domestic economy; and yet, since domestic inflationary pressure was expected to remain mild, the BI Rate was held constant at 6.5% between September and the end of Furthermore, in September 2009 Bank Indonesia also introduced a window repo instrument with a 3-month maturity, while in October 2009 BI implemented a secondary Reserve Requirement (GWM) policy to better manage banking liquidity. In the midst of improved sentiment in the global financial market, the above mentioned policies positively contributed to the developments in various domestic economic indicators. The performances of the Indonesia Composite Index and SUN yield continued to post achievements. The rupiah exchange rate also moved in a strengthening trend. Rupiah appreciation that began in the second quarter of 2009 went on, bringing the rupiah to Rp 9,425 against the US dollar at the end of 2009, or strengthening by 15.65% (ptp) from Rp10,900 for each US dollar at the end of 2008 (Chart 3.3). Along with those developments, inflation expectation continued to subside (Chart 3.4). However, the improved condition in financial market along with the decline in BI Rate has not been responded optimally by domestic banks. This can be seen in the relatively high lending rates which in turn contributed to a weak credit demand. The withhold in credit expansion is one of the reasons behind the mounting excess liquidity stock in banking industry (see Box 3.2. Excess Liquidity and the Implication on Economy). In addition to achieving a fairly good performance in 2009, there has been remaining challenges which will potentially add to the complexity of future monetary policy. Among the challenges are the dynamics of short term foreign capital flows which is potentially influential to the rupiah percent I II III IV I II III IV I II III IV I II III IV I II III IV Volatility (average) Source: Bloomberg (processed) Average Exchange Rate (rhs) Chart 3.3 Exchange Rate and Volatility Rp/USD 12,500 12,000 11,500 11,000 10,500 10,000 9,500 9,000 8,500 8, index I II III IV I II III IV I II III IV I II III IV I II III IV Retailer Expectation Price for 3 months in forward Retailer Expectation Price for 6 months in forward CPI Inflation (rhs) Chart 3.4 Inflation Expectation percent, yoy CHAPTER III Monetary Policy Response to Global Economic Crisis

9 exchange rate development; high risk perception and excess liquidity which can distort the monetary policy transmission mechanism; and the unresolved structural issues in the supply side which may push inflationary pressure up. Those challenges will be further examined in the next section. Monetary Policy Response to Global Economic Crisis CHAPTER III 83

10 The Dynamics of Foreign Capital Flows 3.2 As a small-open economy, developing countries generally face a fundamental challenge when implementing monetary policy in regard to the high dynamics in foreign capital flows. The openness of capital account accompanied by the strong capital flows make exchange rate movement more affected by capital flow activity than the current account. It is worth noting, however, that exchange rate dynamics with open capital account may incite vulnerability in financial system. A more fluctuative capital account compared to the current account in the midst of herding behavior can drive excessive flows or, on the contrary, a sudden stop in capital flows. Moreover, any increases in capital flows, especially the short term ones, will result in elevated volatility in the financial market and will potentially turn into shock amplifier. 48 in the middle of weak infrastructure and minimal financial market depth such that of a developing country. It will certainly exacerbate the impact. The foreign capital inflows in a form of large portfolio investment and the relatively weak structure of financial market put developing countries into a vulnerable position against a sudden stop in capital flows. This could produce large exchange rate depreciation, such as during the 1997/1998 currency crisis that rocked many developing countries, including those in East Asia. Other than a sudden stop in capital flows, a major depreciation can also be caused by a shock to the terms of trade or to 48 Pruski, Jerzy and Piotr Szpunar (2008). Capital Flows and Their Implications for Monetary and Financial Stability: The Experience of Poland, BIS Paper No CHAPTER III Monetary Policy Response to Global Economic Crisis

11 millions of USD millions of USD *annualized Direct Investment Portfolio Investment Other Investment Chart 3.5 Capital and Financial Account Composition Current Account Capital and Financial Account * annualized Chart 3.6 Current Account and Capital and Financial Account the international interest rate. In a developing country adopting an open capital account and applying ITF as a framework in its monetary policy, the floating exchange rate system is an optimum option in accordance with the principle of impossible trinity. 49 The growing role of capital flows is also experienced in Indonesia. In the 1990s period capitals inflow to Indonesia were mainly foreign currency denominated debt (foreign debt). In 1997/1998, when rupiah was severely depreciated, the vulnerability of corporations having a foreign exchange exposure in their financial structure increased. This added pressure to macroeconomic stability and brought down the performance of the overall economy. This state was due to a lot of imperfectness in the market and the financial instruments. In 2000s, there are push and pull factor which accelerated the integration of the domestic economy into the global economy through financial markets (financial linkage). Increasingly rapid capital flows entering Indonesia were supported by interactions in the global developments serving as a push factor, while domestic developments act as a pull factor. Meanwhile, the global economy is facing a global imbalance amid an overly loose monetary policy and a large foreign exchange reserves accumulated by some developing countries. This will in turn trigger global excess liquidity. Meanwhile, pull factors were originated from various domestic conditions such as a deregulation policy to set up a free exchange rate system, a favorable exchange rate regime, and a strong optimism among real sector actors. Furthermore, the appeal of capital flows is also influenced by supports from a more prudent macroeconomic policy, both fiscal and monetary particularly after 1997/1998 crisis. In line with a further financial integration, the capital flows entering Indonesia have been increasingly more characterized by investments in the form of portfolio. In the period and subsequent periods, the augmentation of portfolio investment in Indonesia generally seemed to exceed the capital inflows in the form of Foreign Direct Investment (Chart 3.5). This kind of condition brought positive impacts such as a further diversification in financing sources, market deepening, and an incentive to improve governance. However, as the intensity of financial linkage grows higher, any changes in global perception will bring immediate repercussion to domestic market performance. In the case of a worsening global performance, such a relationship can be asymmetrical. Meaning, any pressures in the global market can immediately trigger excessive asset price fluctuation, high financial vulnerability, and financial system tendency to act as a shock amplifier (as the domestic market is not yet efficient enough to absorb risks. 50 ) The herding behavior and sudden stop phenomena will further strengthen the characteristics of the financial sector which tends to act as a shock amplifier. 49 Impossible trinity or the policy trilema is an international economic term which means that a country can only choose 2 out of the total 3 following policies: fixed exchange rate, free capital flows, and an independent monetary policy. 50 This condition is different from the assumption commonly used in macroeconomic analysis that a financial system endogenously follows macroeconomic developments while acts as a shock absorber within economic activities (shock absorber). Monetary Policy Response to Global Economic Crisis CHAPTER III 85

12 An excessive capital outflow implicated by a herding behavior and a sudden stop takes its toll on shrinking rupiah exchange rate and domestic financial asset value. Facts show that during 1997/1998 crisis rupiah s plummet was accompanied by a severe fluctuation as it depreciated by around 85% during the July 1997-June 1998 period. Indonesia Composite Index suffered a sharp drop by 62% in June 1997-September 1998 period. In addition, during a mini crisis in 2005 SUN yield climbed sharply by 16%, while Indonesia Composite Index was down to the 1,058 level. 51 In the 2008 economic crisis, Indonesia Composite Index fell by 54%, while SUN yield was corrected by 20% during the period of February- November The dominant role of portfolio investment in capital and financial accounts push rupiah exchange rate volatility up. The growing share of portfolio investment within the balance of payment makes rupiah pricing vulnerable, since it is more affected by any changes in investors risk perception within the global financial market than by fundamental factors. This is made more complicated by the phenomenon that the capital flows from the current account, is not fully suppllied the domestic foreign exchange market (Chart 3.6). Some exporters prefer to put their export-generated foreign currencies in overseas placements due to a number of reasons such as (1) the policy of their parent companies, especially for foreign subsidiaries; (2) terms and condition of the Master Loan Agreement, mainly for the exporters who rely their financing on loans; and (3) efforts to optimize the advantage of services provided by overseas banking to the exporters who are also importers at the same time. The dynamics of an exchange rate which is more affected by portfolio capital flow creates a complexity for monetary management. This is due to the changes in interest rate that will not automatically affect exchange rate movement both through domestic demand channels and financial channels in referrence to the concept of Uncovered Interest Parity (UIP). A measured and prudent policy interest rate setting is indeed able to build up market confidence. However, in times when global condition is overwhelmed by high uncertainties, UIP postulate does not always work, even for developed countries adopting ITF. To the Indonesian economy, these things have added to the complexity of the policies given that exchange rate 51 In 20 October 2005, or depreciated by almost 2% since the end of September remains highly influential to domestic prices (pass-through impact). 52 The strategy to manage capital flows and exchange rate should be done in line with a flexible ITF implementation. Under general ITF framework, a floating exchange rate system is a strategic choice for an economy. However, in a condition where the role of rupiah exchange rate tends to act as a shock amplifier and where there is relatively high inflation pass-through, the strategy in exchange rate management needs to be reinforced by policy strategies other than one using interest rate as its main policy instrument. The example of such policy is measured intervention in the foreign exchange market to reduce excessive fluctuation in rupiah exchange rate (smoothing). 53 It is worth noting that central bank s intervention into the foreign exchange market brings a psychological effect to the exchange rate movement and serves as an effective agent to influence a short term exchange rate, especially when compared to the response against interest rate based policy. 54 In this regard, the strongest effect of this policy mainly hit developing countries as their markets are smaller while their central banks are relatively better informed than the market players. In the case of Indonesian economy, the application of the highly flexible exchange rate system inclines to add a depreciative pressure. In such a condition, the Bank Indonesia s policy toward foreign exchange market is carried out in a measured way over a certain period and degree, thus keeping a depreciative pressure on hold and preventing inflation expectation from sparking. However, the policy is not sustainable when not reinforced with efforts to reach the inflation target. Therefore, commitment and consistency of monetary policy in order to achieve the targeted inflation level should always be continued. This will increase monetary policy credibility, which is in turn will help to create a low and stable 52 Conceptually, under a floating exchange rate system the potential of a pass-through effect from the exchange rate to domestic prices is low (Hufner, Felix. Foreign Exchange Intervention as Monetary Policy Instrument: Evidence for Inflation Targeting Countries, ZEW Economic Studies ). However, an idle UIP (caused by, among others, the domination in portfolio capital flows) leads to a high pass-through effect of exchange rate to imported goods prices. 53 Accompanied by sterilization (sterilized intervention) to put a neutral impact to liquidity. 54 Disyatat, Piti and Gabriele Galati (2005), The Effectiveness of Foreign Exchange Intervention in Emerging Market Countries: Evidence from Czech Korona, BIS Working Paper CHAPTER III Monetary Policy Response to Global Economic Crisis

13 inflation expectation. Such an achievement will also relax the pass-through impact on an unexpected depreciation. Finally, it can be concluded that the rise in capital flows among countries in the world will in turn affect domestic policy. The development in global market nowadays contributes to improved discipline in monetary and fiscal policies. This is done by punishing poor policies and rewarding excellent ones. The efforts to discipline monetary policy are carried out by, among others, implementing ITF, and by reinforcing the commitment in the policy to improve transparency among economic actors. The global financial crisis shows that price stability will not guarantee stability in financial system. The strong capital flows among countries made exchange rate more affected by capital flows than the current account condition, which serves as a better reflector on economic fundamentals. Therefore, the role of monetary authority in developing countries will not only be limited to managing interest rate policy, but also to monitoring the behavior of capital account, executing interventions along with sterilizations in times of severely fluctuating exchange rate movement, and developing and deepening the domestic financial sector in a bid to make it more capable of absorbing shocks. Monetary Policy Response to Global Economic Crisis CHAPTER III 87

14 Monetary Policy Transmission in the Midst of High Risk Perception and Excess Banking Liquidity 3.3 Monetary policy face challenges from distorted transmission mechanism. In normal circumstances, monetary policy is expected to be capable of directing economic activities effectively. Theoretically, monetary policy response is transmitted through a number of channels such as interest rate, credit, corporate balance sheet, asset value, and exchange rate. In Indonesian context, since the start of ITF implementation in July 2005 monetary policy has put interest rate as its operational target. In this case, policy signals are transmitted through interest rate policy setting, namely BI Rate. By using various monetary instruments to affect the liquidity in money market, the Bank Indonesia s policy is transmitted through various channels, which in turn will affect domestic demand and inflation. The logic of the interdependency among variables in policy transmission mechanism is illustrated in (Diagram 3.1.) Generally, the monetary policy transmission has run well in financial markets, especially in stock, government bonds and mutual funds markets. Loose monetary policy seems to be favorable to support improvement in confidence amid the initial recovery in fundamental condition. In 2009 Indonesia Composite Index recorded an annual growth of 87% underpinned by the mining sector (Chart 3.7). In addition, government bond yield significantly declined in comparison with the level during the peak of the global financial crisis (October 2008). The average SUN yield for all tenures declined to 246 bps, which was dominated by short term yield (Chart 3.8). The decline in SUN yield for short, medium and long term maturities were at 375 bps, 239 bps, and 130 bps respectively. The mutual fund Net 88 CHAPTER III Monetary Policy Response to Global Economic Crisis

15 Money Operation OMO Corridor Money Market Liquidity Interest Rates Credit Balance Sheet Total Supply OUTPUT GAP Domestic Inflationary Pressure BI Rate Forex Intervention Minimum Reserve Requirement Monetary Variables Asset Prices Price Expectation EXCHANGE RATE Total Demand External Inflationary Pressure INFLATION Diagram 3.1 Monetary Policy Transmission Mechanism Asset Value posted a robust growth reaching Rp113 trillion or up Rp38.7 trillion compared to 2008 level. The types of mutual fund which contributed to the jump in NAB were mainly the protected and fixed-income ones. During a recovery from crisis period, monetary policy transmission was indicated to work through liquidity channel. That was made possible as a consequence of Bank Indonesia s effort in managing liquidity and the assumption of a stable money multiplier of narrow economic liquidity (M1). In addition, the relationship among the real M1, interest rate and the real economic growth seemed stable enough in the long run. Under such a relationship, the slowing M1 growth reflects more on the severity of the impact from deteriorating economic activities than the impact from a decline in deposit rates. This implicitly indicated that M1 condition was in line with the real activity needs within the economy (Chart 3.9). 55 However, the global economic downturn forced monetary policy transmission process to face some challenges. The spreading effects of the global economic crisis were strong enough to drive the economy to slowdown and 55 Conducted by comparing test results using standard currency demand function to actual currency demand condition. If the relative test result is equal with the actual condition (deviation within a standard error range) then the currency demand matches with economic needs. 3,000 2,500 2,000 1,500 1, index I II III IV I II III IV I II III IV I II III IV percent percent I II III IV I II III IV I II III IV I II III IV JCI BI Rate (rhs) Yield Government Bond BI Rate Source: Bloomberg (processed) Source: Bloomberg (processed) Chart 3.7 BI Rate and JCI Chart 3.8 BI Rate and Yield Government Bond Monetary Policy Response to Global Economic Crisis CHAPTER III 89

16 M1, M2 (percent, yoy) M1 Chart 3.9 Growth of Nominal M1 and M2 latter pushed economic actors, mainly in the banking industry, to be more prudent and risk averse. This was quite common due to the fact that financial system tends to be procyclical. 56 However, under a crisis period such behavior was reinforced by the existence of the financial accelerator. 57 Amid the persistency in excess banking liquidity and the lack of response in the supply side thus reducing the effectiveness of macroeconomic policy stimulus transmission toward the real sector all of those factors mentioned above became obstacles for monetary policy transmission mechanism through the use of interest rate and credit channels. g Interest Rate Response The effectiveness of the BI Rate s influence on various interest rates in money market and banks has improved over time. Initial tests on the hypothesis of 56 Bank Indonesia s Directorate of Economic Research and Monetary Policy (2009), Review on Inflation Targeting Framework (ITF) Implementation in Indonesia, Working Paper, December. 57 Financial accelerator means that credit market distortion will further strengthen economic shocks. The distortion, which is supposed to be minimal under an efficient market, will turn to be an excessive and protracted one under an imperfect credit market condition. M2 the term structure of interest rates 58 during the ITF 59 implementation era shows that generally monetary policy transmission mechanism through interest rate channel works. 60 Transmission effectiveness in the effect of BI Rate onto Inter-Bank Money Market Overnight (PUAB O/N) interest rate improved very significantly (Table 3.1). This is related with the positive aspect of operational framework improvement including the narrowing of the interest rate corridor especially since early PUAB O/N interest rate,which was moving closely against BI Rate in a narrow range, has been transmitted into PUAB interest rate in various maturities in a relatively similar magnitude. However, it is worth noting that the effect of PUAB interest rate to deposit and lending rates and the effect of deposit rate against lending rates are not as strong as the effect of BI Rate against PUAB O/N interest rate. This is connected with a number of micro conditions faced by market players amidst the prevailing perception against macroeconomic condition which was not fully recovered after the global economic crisis. However, during a crisis period the magnitude of a decline in lending rate turned to be much smaller than the decline of BI Rate and deposit rate. Data observation shows that the gap between lending rate and deposit rate has grown wider. The same thing also occurred to the gap between Lending Base Rate (LBR) and BI Rate. When further analyzed based on micro bank perspective, 58 A long term interest rate is a weighted average of short term interest rates (future short term interest rates). 59 Under an ITF regime with an interest rate as an operational target basis,the assumption applied is that through a policy rate setting under a monetary operation (liquidity management), a central bank can affect current and expected O/N interest rate (shortest market interest rates), fund/credit market interest rate (longer term interest rates), thereby, real economic activities. 60 Hypothesis test on term structure of interest rates was carried out by Vector Auto regression approach (VAR), by applying 2 lag periods. Exogenity assumption on interest rate behavior in such systems, namely SBI 1 month (represents policy rate ), PUAB O/N, Deposits,and Credit. The prediction result is shown by Variants Decomposition Analysis, namely a portion in a variation change of a variable that is explained by a change in another variable. Period Table 3.1 Variance Decomposition: Impact of variable for the next 1 to 3 months SBI --> Interbank Money Market Rate Interbank Money Market Rate --> Deposit Rate Interbank Money Market Rate --> Credit Rate Deposit Rate --> Credit Rate 1 month 3 months 1 month 3 months 1 month 3 months 1 month 3 months July August ,1 1,9 0,7 0,9 0,9 2,3 6,7 10,5 January August ,5 3,1 1,5 1,8 3,8 3,9 15,1 19,5 July August ,5 43,6 3,7 6,4 1,7 6,9 28,4 32,8 90 CHAPTER III Monetary Policy Response to Global Economic Crisis

17 percent percent percent Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec -08 May-09 Oct-09 Spread ob BI Rate and COF Spread of Based Lending Rate and BI Rate Source: Bloomberg Chart 3.10 Spread of BI Rate-COF and Based Lending Rate-BI Rate Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Source: Bloomberg Spread of lending and deposit rates Spread of lending and based lending rates Chart 3.11 Spread of Lending rate with Based Lending Rate and Deposit Rate some factors contributing to the lending rate movement include the cost of fund, risk premium that tended to rise during lending rate formulation, and profit margin. 61 An initial observation using ex-post data from banking financial reports indicates that the decrease in an aggregate banking cost of fund throughout 2009 tended to be slower than the BI Rate decline (Chart 3.10). Furthermore risk premium in the economy was still perceived to be high as reflected in the spread between LBR and the actual lending rate (Chart 3.11). Additionally, the 2009 also saw an indication that the banking industry prefers to maintain their profit margin. 62 Efforts to strengthen the internal condition of banks by competing to draw public fund, charging a greater business risk (risk averse), and also accumulating profit seemed contradictive as the real sector was still in recovery process. On the contrary, this condition can also be perceived as banking prudential efforts given the still nascent improvement in global financial market. The slow adjustment in lending rate has its root in the variety of the bank sizes and their targeted business sectors. In this condition, banks were allowed to compensate their inefficiency on higher lending rates. Moreover, the high banking profit margin as seen in their Net Interest Margin (NIM) position was indicated to hinder the lending rate reduction. This situation was exacerbated by the tendency that the greater the bank is, 61 In line with Gambacorta, Leonardo (2004), How Do Banks Set Interest Rates? NBER Working Paper Series No that industrial structure, cost of loanable fund, overhead cost and risk premium affects credit pricing formulation. 62 In the long run it is feared to heighten the risk due to an appearing adverse selection, namely the debtors who prefer to take a high lending rates tend to be those having a high risk. the less responsive it is against any changes in monetary policy. This phenomenon was in line with several studies in the past on lending rate rigidity and banking efficiency. 63 In addition, within the general credit market, there is a leader and a follower behavior to determine interest rate. 64 Moreover, the year 2009 also saw an expanding role of Small, Micro and Medium (SME) credit. Given their characteristics, MKM borrowers tend to focus on credit access compared to lending rate, making the formulation of lending rate more complex. The banking excess liquidity, which tends to be persistent, comes as another factor that can explain the hindered response against interest rate. A persistent and structural excess liquidity is deemed as a heavy challenge in a bid to implement the monetary operation framework. Such a challenge, if not well managed, will take its toll on a high volatility in PUAB interest rate, which in turn will undermine the exchange rate stability and the effectiveness of monetary policy transmission. The deviation and volatility of PUAB interest rate, which are 63 On Agung, Juda, Bambang Mukti Riyadi, and Nugroho Joko Prastowo (2002), Banking Interest Rate Rigidity, Research Note, Directorate of Economic Research and Monetary Policy, Bank Indonesia; for instance, says that interest rate rigidity is related with, among others, banking balance sheet condition and credit market structure tended to be more concentrated. This is reflected in the highest rigidity of the recap banking lending rates due to the asset structure of the group of banks which is still dominated by government bonds. Hadad, Muliaman D, Wimboh Santoso, Eugenia Mardanugraha, Dhaniel Illyas (2003), Parametric Approach for Banking Efficiency in Indonesia, Bank Indonesia s Financial System Stability Bureau, Research Paper No. 4/5; says that major banks efficiency is not better than in those of foreign banks and joint venture banks. 64 Kahn, Pennacchi and Sopranzetti (2000), Bank Consolidation and Consumer Loan Interest Rate, The Wharton School. University of Pennsylvania. Monetary Policy Response to Global Economic Crisis CHAPTER III 91

18 higher than the BI Rate, will cost monetary policy its credibility. In addition, some observations show that if excess banking liquidity is failed to be absorbed by the authority, it will in turn pose a potential pressure on monetary stability, inflation and exchange rate. Empirical studies done in a lot of countries show that excess banking liquidity pose the potential to undermine monetary policy transmission. 65 Responding to such a structural excess liquidity issue, the management of excess banking liquidity needs further coordination among monetary, fiscal and banking authorities. g Banking Credit Extension The retention of the lending rate and the growing risk perception caused by the fallout from the global crisis resulted in slower growth of banking credit. During 2009, credit expansion (including credit extension) only reached Rp117.2 trillion (8.7% yoy) adding to a total credit of Rp1,470.8 trillion, much lower than the credit expansion over the same period in 2008 which stood at Rp326.2 trillion (31.2%, yoy) (Chart 3.12). The continued decline in credit growth was mainly attributable to a fall in foreign currency denominated credit growth, which was triggered by export reduction due to the global economic contraction. Meanwhile, rupiah credit also grew at a slower pace in line with the contraction in domestic economy as lending rates remained relatively high Agénor P.R, J. Aizenman, A. Hoffmaister (2000), The Credit Crunch in East Asia: What Can Bank Excess Liquid Assets Tell Us? NBER Working Paper Series No and Saxegaard (2006), Excess Liquidity and Effectiveness of Monetary Policy : Evidence from Sub- Saharan Africa, IMF WP/06/ That is supported by the banking survey results showing that the slow credit expansion is in line with the remained high lending rate Slowing credit growth occurred in all economic sectors, especially in manufacturing industry and service sectors. The fall in credit growth especially hit Working Capital Credit (KMK) in industrial and service sectors, billed as one of the biggest credit absorbing sectors (Chart 3.13). Meanwhile electricity, water and gas sectors grew relatively high in line with the infrastructure development, especially in electricity sector, although when compared to the growth in previous year the sector also suffered a significant slowdown of growth. Such a sectoral credit condition was due to low domestic economic growth caused by disruption in overseas demands. 67 A phenomenon of the slowing credit growth is predicted to be not only rooted in a weak credit demand, but also in the retention of credit supply. A slump in domestic economy will automatically cut financing needs. Meanwhile, the real sector which has yet to fully recover poses to add risk to Non Performing Loans (NPL) making banks more prudent in extending fresh credit. This seems to be in line with the behavior of financial system that tends to be procyclical. 68 In a normal situation or while the economy is expanding, the sensitivity of monetary policy against aggregate macroeconomic variables seems to work in accordance with a general concept. Any changes in policy interest rate correspond with changes in lending rate, and in turn credit extension. This is in line with the hypothesis about the existence of risk taking channel, which stated that financial institutions tends to drop its and economic risk perception among certain economic sectors. 67 The estimation results show that the current actual credit position is already relatively equal with potential credit demand amid a not fully recovered economic condition. 68 Report of the Financial Stability Forum on Addressing Procyclicality in the Financial System, Financial Stability Forum (2009). percent, yoy percent, yoy percent, yoy percent Credit in USD I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV I II III IV Credit in Rupiah Credit in Foreign Currency Total Credit (rhs) Growth of Working Capital Credit Working Capital Rate (rhs) Chart 3.12 Credit Growth Chart 3.13 Credit Growth and Working Capital Rate 92 CHAPTER III Monetary Policy Response to Global Economic Crisis

19 Table 3.2 Interest Rates and Monetary Policy Transmission Mechanism Parameter Response to BI Rate/Loan Rate* Working Capital Invesment Demand for credit Normal phase** - BI Rate - Loan Rate Expansion Cycle during crisis - BI Rate - Loan Rate * estimated using regression method with observation periods started from January 2001 to June 2009 ** normal phase includes expansion and contraction cycles risk perception by easing the credit extension standard. Meanwhile when opposite condition occurs such as during the ongoing global crisis a corrected response manifested in lending rate cut following the drop in BI Rate. 69 The slow response in lending rate cut will later lead to the drop in credit extension (Table 3.2) while the existence of a financial accelerator will further shrink intermediation. 69 In line with the study of Peersman and Smets (2001), The Monetary Transmission Mechanism in the Euro Area : More Evidence from VAR Analysis, ECB Working Paper Series No. 91; European region saw a sensitivity of the monetary policy against economic growth was indicated to be not strong in affecting economic growth when the economy was under a crisis cycle. One of the contributing factors to such a condition is the fallout from the financial accelerator propagation mechanism, which further worsens when the economy is under a crisis cycle. During a crisis, banking industry tends to avoid risk and focus more on maintaining liquidity adequacy. Even, when confronted to a situation with a mounting counterparty risk in money market, banks opt to go on with liquidity hoarding, for instance, by increase their low-risk portfolio placements such as in central bank instruments. This will in turn expand banks capability in absorbing the possibility of deteriorating credit performance caused by the weakening real sector. In the future, the recovering economy is expected to boost credit demand. With this in mind, banks can drop their risk perception, and subsequently their lending rate, creating a favorable environment to improve effectiveness of policy rate transmission to banking interest rate. Monetary Policy Response to Global Economic Crisis CHAPTER III 93

20 Supply Side Condition and Implication on Inflationary Pressure 3.4 The domestic economy continued facing various problems in its supply side, among others were micro structural constraints. Such constraints were mainly in the forms of inefficiency or a high cost economy, disharmony between central and regional regulation, a lack of infrastructure and energy supply, along with low skilled labor forces, which will not only affect the sustainability of economic prospect and macroeconomic stability, but also will decrease Indonesia s relative competitiveness in comparison with other countries in the region. Such micro structural constraints brought about several constraints such as a less responsive supply side against any developments or policy stimulus generated in the demand side, the imperfectness of the market structure for certain commodities, and the inefficiency in trade regulation/distribution line. g Supply Side Response The lack of response in the supply side developments in relation to developments in the demand side is reflected in a steep and less elastic supply curve during a postcrisis period. Empirical observation on the behavior of the supply side as reflected in the Phillips New Keynesian Curve, 70 shows that during a pre-crisis period ( General specification of Phillips New Keynesian Curve is underlied on a staggered price setting model, namely a model which also incorporates a possibility of certain fraction within economic agents to use a backward-looking price adjustment pattern as a rule of thumb. With such a hypothesis, a hybrid model basis can be written as follow: π t = γ b π t-1 + γ f E t {π t+1 } +κ (y t y* t ), in which γ b and γ f are decomposition coefficient from some parameters within a modeling system, simultaneously reflected as backward-looking and forwardlooking behavior of inflation while κ is an output gap parameter. 94 CHAPTER III Monetary Policy Response to Global Economic Crisis

21 Inflation (π e t ) backward-looking tendency forward-looking tendency ± ± ± π e t pre-crisis period post-crisis period global financial crisis in 2008 Output gap (t-2) Chart 3.14 The Behavior of Supply Curve (Phillips Curve) of Indonesia 1997) the short term elasticity of the inflation against output development (output gap) stood at , whereas during post-crisis period ( ) such an elasticity rose to between The observation also finds that the behavior of the Phillips curve was also affected by the fallout of the 2008 global financial crisis, in which the short term elasticity of the inflation toward output before 2008 global financial crisis (1998 third quarter 2008) was recorded at around Furthermore, the inclusion of dummy variables in the basic equation to differentiate the effect between the positive and negative output gap leads to a conclusion that during a crisis period there is a tendency that positive output gap gets higher effect than negative one, which is an indication of an asymmetrical or non-linear behavior of the Phillips Curve The estimation was conducted by using quarterly data. Theoretical assumption was set as γ b +γ f = 1. Estimation method used Generalized Method of Moments (GMM) technique with variables such as inflation lag instrument, current value and exchange rate lag, current value and monetary magnitude lag (M0), and cyclical factor. Output gap variables were estimated by using Hodrick-Prescott Filtration method. The theoretical restriction test showed that nil hypothesis of γ b +γ f = 1 was not rejected. The shown test result of parameter value within the range was related with the differences in the result of estimation between the one which incorporated extreme data behavior during crisis periods, between , and the one which did not. 72 This observation was a revisit on a study about the Phillips Curve in Indonesia, (Solikin, 2004, Structural Changes and Phillips Curve The prediction further confirms three empirical findings on the alteration of behavior in the supply curve which tends to be less elastic due to the structural changes in the economy. Firstly, in times of crisis the slope of supply curve tends to be steeper, meaning that inflation development tends to be more sensitive against output development. This way, with the same amount of demand side stimulus, the affected change in prices tend to be larger. Secondly, the relatively steeper supply curve during period compared to period shows that the 2008 global financial crisis has escalated the potential constraints within the supply side (Chart 3.14). Thirdly, such a structural issue, which affects the behavior of Phillips Curve (tends to be convex in its shape), is in line with the hypothesis about the presence of capacity constraints within the Indonesian economy, mainly occurring during economic crisis periods. This is one of the main factors behind the inflation rigidity. 73 Behavior in Indonesia: Existence, Expectation Formulation, and Non-Linearity, Buletin Ekonomi Moneter dan Perbankan, March). Substantially, the conclusion is similar, namely the structural changes affected by 1997/1998 financial crisis resulted in the Phillips Curve which tended to be less elastic and non-linear in Indonesia. 73 This in line with the analysis conducted by Bank Indonesia that said the movement of inflation permanent component tended to decline, however, still above 5% level. Afandi (2007) Economic Structure and the Implication against Inflation Target in , Research Notes, Directorate of Economic Research and Monetary Policy, Bank Indonesia, 30 October. Monetary Policy Response to Global Economic Crisis CHAPTER III 95